Warning signs: Avoid Titanic’s fate – watch out

In 1997, Hollywood gave us a dramatic view of the crash of the unsinkable Titanic. Last month, the movie was re-released in 3-D. In a recent blog for the Harvard Business Review, Mark Bonchek made a list of business lessons he learned from the Titanic. His blog led to this column topic.

The movie depicts a huge iceberg looming over the Titanic. In actuality, the iceberg was rather small. It was not as high as the bridge and didn’t even make a huge hole. It was difficult to see because the surface had melted into a mirror. Six warnings were received, but all were ignored.

This is interesting, but what does it have to do with business? When talking about threats, humans tend to think of them as big and easily recognizable. Somehow these giant menaces sneak up with no advance warning and cause problems when we are not looking. Some disasters happen that way, of course. Tornados and earthquakes strike with little or no warning and can seriously injure or destroy a business. However, that is not how most businesses are derailed.

Many, perhaps most, risks make themselves known through changes in the business’ financial statements. In an actual example, a business was informed by its adviser that accounts receivable were creeping up, but no plausible reason could be seen. This warning was given three months in a row before the owner decided to look into it.

He was shocked to find his bookkeeper had embezzled almost $100,000 and covered it up via accounts receivable.

In another smaller, but no less disturbing, situation a firm was advised that the petty cash account regularly came up short about $800 each month. The warning came because the account was always short.

If it was a random situation, it should have been over or had excess cash in some months. In addition, the amount should have varied.

After a year, the owner was prodded into establishing a formal control over the fund. The shortages ceased that month. In both cases, the warnings were given, but were ignored.

Financial statement analysis is the basic tool for revealing disaster warnings. The above examples confirm that simple deviation analysis can indicate problems early – when prevention or correction is more easily undertaken.

It almost goes without saying that preventing or quickly solving a problem reduces the ultimate cost to the business. Other straightforward analytic examples include monitoring inventory turns, gross margins and sales trends by product or service line.

The current economic downturn and financial stress has resulted in many unexpected disruptions and bankruptcies.

An aerospace manufacturer’s supply line was adversely affected by a number of such disruptions during the past three years.

Although quite costly, the firm believed there was nothing it could do to avoid them. Sophisticated financial statement analysis can, however, predict financial disruption and bankruptcy as much as two years in advance.

Understand how to detect threats while they are small. Don’t ignore the warnings. Remember the Titanic.